Mises Daily Articles

The Snare of Government Subsidies

In 1977, Lew Rockwell was the editor of Private Practice, a journal of medical economics. That year, he put together three teams of speakers to present evening seminars for physicians in three dozen cities. The teams made the case against tax-funded medicine.

On each team was a physician from Canada, one from England, and maybe one from Australia, each with horror stories to tell on the practice of medicine under tax-funded medical health care delivery. There was also an American physician and one non-physician. As I recall, there was also a Congressman.

I was on one of those teams. We hit a dozen cities in fourteen days. It was the toughest speaking assignment I have ever had.

The reaction was not spectacular. The physicians in the audience did not seem to recognize the threat to their practices that bureaucratic medicine involved. Most of those physicians are in retirement today. Before most of them had retired, they saw American medicine move in the direction of bureaucratic medicine, just as we had warned.

Younger physicians today do not recall what it was like to practice medicine in the good old days. But the good old days of 1977 were not all that good. From the era preceding World War I, when the Rockefeller Foundation promoted the government-licensing system that restricted entry into the profession by controlling medical education, the march into the trap of tax-funded medicine began.

When I returned from my whirlwind tour, I decided that I would write an essay on the threat to American medicine posed by the State. I wrote it. It was published in The Freeman in May, 1978. I titled it, "Walking into a Trap."

Walking into a Trap

There is some justification at least in the taunt that many of the pretending defenders of 'free enterprise' are in fact defenders of privileges and advocates of government activity in their favor rather than opponents of all privilege. In principle the industrial protectionism and government-supported cartels and the agricultural policies of the conservative groups are not different from the proposals for a more far-reaching direction of economic life sponsored by the socialists. It is an illusion when the more conservative interventionists believe that they will be able to confine these government controls to the particular kinds of which they approve. In a democratic society, at any rate, once the principle is admitted that the government undertakes responsibility for the status and position of particular groups, it is inevitable that this control will be extended to satisfy the aspirations and prejudices of the great masses. There is no hope of a return to a freer system until the leaders of the movement against state control are prepared first to impose upon themselves that discipline of a competitive market which they ask the masses to accept." – F. A. Hayek1

The idea that businessmen are strong defenders of the free enterprise system is one which is believed only by those who have never studied the history of private enterprise in the Western, industrial nations. What businessmen are paid to worry about is profit. The problem for the survival of a market economy arises when the voters permit or encourage the expansion of government power to such an extent that private businesses can gain short-term profits through the intervention into the competitive market by state officials. Offer the typical businessman the opportunity to escape the constant pressures of market competition, and few of them are able to withstand the temptation. In fact, they are rewarded for taking the step of calling in the civil government.

The government's officials approve, but more to the point, from the point of view of the businessman's understanding of his role, shareholders and new investors also approve, since the favored enterprise is initially blessed with increased earnings per share. The business leader has his decision confirmed by the crucial standards of reference in the market, namely, rising profits and rising share prices on the stock market. No one pays the entrepreneur to be ideologically pure. Almost everyone pays him to turn a profit.

This being the case, those within the government possess an extremely potent device for expanding political power. By a comprehensive program of direct political intervention into the market, government officials can steadily reduce the opposition of businessmen to the transformation of the market into a bureaucratic, regulated, and even centrally-directed organization. Bureaucracy replaces entrepreneurship as the principal form of economic planning. Bureaucrats can use the time-honored pair of motivational approaches: the carrot and the stick. The carrot is by far the most effective device when dealing with profit-seeking businessmen.

Those individual enterprises that are expected to benefit from some new government program have every short-run financial incentive to promote the intervention, while those whose interests are likely to be affected adversely — rival firms, foreign enterprises, and especially consumers — find it expensive to organize their opposition, since the adverse effects are either not recognized as stemming from the particular government program, or else the potential opponents are scattered over too wide an area to be organized inexpensively. The efforts of the potential short-run beneficiaries are concentrated and immediately profitable; the efforts of the potential losers are dispersed and usually ineffective.

The expansion of political power in the market process has been going on in the West for about a century, at least in the modern form of interventionism, starting with the social security legislation of Bismarck's Germany in the 1870s. Governments have evolved a strategy by which whole industries or professions are captured by the bureaucratic state. While this strategy is not the only one used, in peacetime it has proven enormously successful. (Nothing, of course, favors political centralization more than war.) I have outlined this strategy by means of the following analogy:

Baiting the trap

Setting the trap

Springing the trap

Skinning the victim

1. Baiting the Trap

Extra-Market Benefits

The politicians enter an otherwise competitive market situation with an offer to promote certain industrial or professional programs. Taxpayers' money is used to finance this program, but it is rare for the potential short-run beneficiaries to reject the offer on these grounds. Certainly, a majority of those who are to be the recipients of the special favor gladly accept it. They see their goals as being part of the public interest, and they view an offer of government aid as being only natural. They see it as their due. Those who refuse to take the special favor risk lower profits in the immediate future, since competitors in the industry or professional association will take the favor. The general attitude is this one: "If I don't take it, somebody else will." As a statement of fact, rather than principle, it is absolutely correct. Somebody else will.

There are several possible forms in which the aid may come. Industrial groups may receive tariff protection, which is a tax levied on consumers on both sides of a border over which trade had been carried on or over which it might be carried on in the future. Consumers pay higher prices on both sides of the border. There can be no grants of government economic benefits without someone or some group bearing the costs. A tariff is a tax.

For professional groups, another approach is offered. It is usually in the form of licensing, which is a grant of monopoly rents to those inside the protected profession. The profession elects representatives who sit on government boards, or who actually make up the whole board. They can police entry into the profession's ranks by unqualified competitors, meaning those who have not passed certain educational and/or skill requirements established by the board. Most professionals believe that such restrictions on entry are entirely natural for the sake of preserving the present-day standards of practice that the majority of the profession accepts.

Like the businessmen, they see these benefits as normal, natural, and altogether beneficial to the public. Result: higher fees and fewer choices. Another way to buy off almost any industry or professional association is by means of direct grants of money. The government may simply buy products from a company. It may establish government research grants. It may subsidize certain industries directly. In the case of the great railroads in the United States which were built in the 1860s and 1870s, the government offered millions of acres of land to the railroad companies as an incentive to begin and complete construction.

Perhaps the most popular form of subsidy is tax relief. Certain occupations, companies, or organizations receive tax breaks. In an era of growing taxation, this approach has been one of the most effective; the higher the tax level, the more advantageous is tax exemption. The American oil industry was the recipient of multiple tax breaks until quite recently, and they are still substantial.

All of these special favors are adopted in the name of the general welfare of the public. All of them involve the financial incentives for private individuals and firms to conform themselves to the goals set forth by the sponsoring agency, the government. All of them involve the transfer of wealth from consumers and taxpayers to the beneficiaries. All of them involve a temporary suspension of market forces and a redirection of those competitive pressures. All of them necessarily involve a reduction of the sovereignty of the recipients, since they become partially dependent on the government for continued benefits.

In short, the bait is most tempting.

2. Setting the Trap

Extra-Market Costs

The government is a political organization. Its justification is that it is an agency of the popular will, an agent of the public in its political capacity. It is therefore an agency of public defense. The general public is to be protected from adversaries, including domestic adversaries. In a limited-government system, this means that those who use fraud or violence against their neighbors are to be penalized. In modern interventionist states, the concept of public defense is much broader.

The government cannot lawfully make grants of power or money to any group unless it is in the public interest to do so. In short, the state must police those who are subsidized by the state. The money cannot be used exclusively for the benefit of private citizens. The long arm of the law is at the end of the strings attached to every grant of monopoly power or special favoritism. In theory, every dollar spent by the government must be accounted for, to make sure that the public's interest is upheld in each expenditure. The result, among others, is an endless proliferation of forms.

The state grants a particular group special favors. But it cannot do so randomly. It must have a purpose, officially and unofficially. The official purpose is not nearly so important as the unofficial purpose. The official purpose is offered to calm the public (which must finance the grants) and to make sure that the judiciary does not intervene. The unofficial purpose is almost universally this one: the expansion of political power at the expense of private associations.

Once the grant has been made, the beneficiaries use it for their purposes. The money is spent. Parkinson's Law takes over: expenditures rise so as to equal income. But expenditures are always difficult to reduce, especially in large, bureaucratic organizations. The firms become used to the higher income. The income becomes part of annual forecasts. Managers expect it to continue. After all, they are all agreed that such subsidies are in the national interest. Would the nation (the politicians) revoke their trust? Never! The organization is hooked. It has become dependent on the continued favors, meaning the continued favor, of the state.

Inevitably, one firm or some individual begins to take advantage of his position. He exercises the monopoly grant of power which the state provided for him. He charges a bit too much. He starts running a "factory." Or the firm or individual cuts quality. In short, someone actually begins to milk the system.

The Patterned Response

Some of us have become cynical over the years. We have so often seen this pattern, and the government's equally patterned response, that we have been inclined to come to a startling conclusion, namely, that the government establishes the system in order that some beneficiary will milk it. That is a primary purpose of the system of government favors.

Once the pattern of "exploitation" is detected by citizens or government officials, not to mention bureaucrats at any level of government, the response is politically inevitable. Someone calls for the government to do something about the unfair use which is being made of the government's trust. Some firm or some professional must be stopped, and stopped now. The industry or guild must be policed. The consumer must receive protection from the unscrupulous.

The industry leaders naturally resent this intrusion into the semi-free market. They resent the fact that someone is milking the system. That person, for one thing, is trying to get more than his "fair share" of the booty. Also, he is making the government angry. He is threatening the continuation of the subsidy. He is violating professional standards.

This appeal to professional standards is very important. The government knows what appeals to make, and this is a good one. (The industrialist is not nearly so alert to such violations, since the agreed-upon standards are not so clear.) The ethics of the professional association are at stake. They must be defended. Yet it is extremely expensive to enforce standards on a colleague. Friendships are at stake. Careers are at stake. And counter-suits are at stake. Yet a small percentage of incompetents (usually said to be about 3 percent by every representative of the professional association) threaten the semi-autonomy of the group. (There is no real autonomy if the government has granted some sort of favor.)

Need for Policing

The government demands that the industry or professional group police itself. The market as a policeman has been compromised by the original grant of power or money. This compromised policeman — the consumers — cannot enforce its decisions inexpensively, given the government grant. So the government calls on the group to police itself, and it draws up certain standards that should be met. The "partnership" between government and professionals grows strained. So the industry or professional group elects (or more likely accepts) certain spokesmen who will "work with" the other partner. This supposedly will insure that the interests of the government and the favored group will mesh, and that the group will continue to receive its favors. On this point, I can do no better than to quote Enoch Powell, the former M.P. in Great Britain. He makes quite clear what the industry can expect.

"They start more than half-beaten, by the very fact that they are, or claim to be, the spokesmen and representatives. It has been their pride and occupation to 'represent' industry to the Government. Yet the safest posture for an industry confronted by Socialism would be not to have an organization or spokesmen at all. Instead of being able to coax, browbeat or cajole a few 'representative' gentlemen into co-operation, the Government would then, unaided and at arm's length, be obliged to frame and enforce laws to control, manage or expropriate a multitude of separate undertakings — the true picture of private enterprise — with no means of getting at them except the policemen."

Powell is here speaking of an industry which is not on the receiving end of major government favors. If government has the industry on a string, it need not have to resort to the policeman. All it needs to do is to cut off the subsidies, and the whole industry is put into a financial crisis. The existence of the subsidies calls forth the "industry's spokesmen." And to quote Powell, "As soon as 'our President, Lord So-and-So' is in a position to talk about what such-and-such an industry 'wants' or 'thinks', that industry is on the road to the scaffold…. The Association of these, the Federation of those, present just that one neck to the Socialist garroter."2

Once the government uses the bureaucratic garrotte to strangle the representative of the industry who stands in place of all the members, there is no way out except to repudiate the compromiser who stuck their collective necks into the garrotte. If they do not pull out their own necks, they will suffer the same fate.

The professional guild is perhaps the most vulnerable, since the very nature of the "bait," namely, a monopoly position based of guild-policed licensure, creates the very policing organization necessary for the government to impose its will at lowest cost. They can be appealed to on the basis of professional standards and the guild's responsibility to a vaguely defined public, irrespective of the individual professional's ability to satisfy the needs of specific members of the public.

3. Springing the Trap

Extra-Market Crisis

More cheaters are discovered. The guild waffles. The cheaters continue to operate. The press scents blood and headlines. Politicians scent blood and votes. When they look into the actual operation of the industry, they find more examples of men or firms that have gouged the public, meaning people who are taking advantage of the very system that the government created - an eminently exploitable system. So the reports of cheating and fraud continue. The reports continue, but no prosecutions are begun by the government, since nothing specifically illegal has been detected. The guild is powerless, obviously, for the same reason. This means that the reports are going to continue. The guild will still be under pressure to do something to stop the causes of the reports. Finally, new laws are called for to clean up the industry, since the industry is seemingly incapable of policing itself.

For professional associations, this is a disaster. Members have been led to believe that there are standards of practice within the profession. Yet these reports keep hitting the front pages. Their self-esteem is challenged. They begin to wonder what has gone wrong. Maybe the reports are correct. Maybe the government needs to do something — not anything drastic, of course, but enough to clean up the temporary mess and let honest men continue to practice. They miss the point: the government's task is to alter the practice of the honest men. The government wants to set all standards and enforce them. There will then be no doubt about who the senior partner is. Bureaucrats want control.

The crisis is not created by the negative reaction of consumers. Businessmen do not find that one morning sales are down 30 percent because the public has decided to walk away from the fraudulent segments of the industry. Professionals do not find their offices empty for weeks on end. In short, it is not the market which drives home the message to the supposedly crisis-bound industry or profession. The critics come from outside the market, probably from those who seldom use the products or services involved, or if they do, who find the products or services quite adequate in their particular cases. But the crisis is no less real, for the public and even members of the associations perceive it as a crisis. This means that the crisis is real politically. "Politically" is what counts in an era which is socialist or interventionist in its economic outlook.

What about the representatives of the industry? Will they co-operate? Powell answers straightforwardly:

"You bet they will. They are afraid not to. They are afraid of being pilloried by the Government and its political supporters as 'unpatriotic' or simply (damning word) 'uncooperative.' They feel that the eye of the public will be upon them, and they do not like the adjectives which they foresee would be liberally used inside and outside Parliament — and will be, anyhow, before the end of the day. Of course the line of true patriotism would be the opposite to the one they are going to take. It would be to protest, by all means in their power, short of breaking the law, against every kind of error and nonsense as it comes along, and to oppose in their own industry any measure which does not commend itself to their knowledge and experience. But they shrink from this because, although they have no seats to lose and no voters to offend, it takes courage of a special kind — political courage — to outface authority and the popular cry of the hour. These men have commercial courage, and no doubt physical courage too; but facing the political music is something they have neither been trained nor volunteered for. So they play along with the search for an incomes policy, or export incentives, or whatever else it may be."

And, as Powell points out, "The effect is doubly damaging; for it also hamstrings any politicians who are prepared to raise their voices in protest." The public thinks it strange that industry representatives have not protested the accusations by the government. Apparently, the leaders approve of the government's policies. "Thus the co-operators effectively expose the flank of the anti-Socialist opposition and compel it to fall back on positions which are better protected."3 But not much better protected, he might have added.

Once the crisis is admitted to exist by the leaders, though of course on a much reduced scale — 3 percent of our members, not 20 percent — the battle is pretty well lost. To clean up that 3 percent, the government will alter the entire foundation of financing, policing, and pricing of the industry's services. The corruption will escalate, but now it will be a government problem, to be met by even more intervention. More laws can be passed, more penalties handed out, more regulations enforced: the government expands its control relentlessly. The trap has been sprung.

4. Skinning the Victims

Extra-Market Bankruptcy

There are any number of ways that the government can see to it that the former subsidies now become the straitjacket for the former beneficiaries. The most obvious method of control over professional groups is the establishment of government control boards that will enforce standards and price. The government begins to finance the guild more directly. The former monopoly grant now becomes direct payments. But these payments have no strings attached; they are ropes, or even chains. The government sets fees, allocates equipment, and assigns consumers (clients). The government directs the operation of the association through its captive agents, the profession's representatives. Members of the profession are told what they will be paid, the kind of service to be offered, and the quantity of service to be dispensed.

The government also establishes some sort of quality-control standards. These are enforced by quality-control boards made up of compliant members of the profession and representatives of the public (pressure groups) and the government (bureaucrats). These quality-control boards do exactly that: control quality. If quality, meaning cost, starts going up, then they step in and control it. They ration equipment. They set lower standards of care, especially in government hospitals or clinics. They make sure that costs are held down, since the government, not the consumer, is paying the bill. No matter what guild is involved, the government makes sure the "irresponsible quality" is avoided, meaning irresponsibly high quality.

The government forces industries to operate at a loss. The classic example in economic history is the American railroad system. Created by government subsidy, controlled in the name of protecting the consumer, the railroads in the Northeastern part of the United States, as well as the Midwest, have been strangled to death. The Interstate Commerce Commission was the first Federal regulatory agency in the United States, established in 1887. It was established in the name of protecting the consumer, but as the New Left historian Gabriel Kolko has argued, along with free market economists like Milton Friedman, the result was a freezing out of new competition, since the ICC established rate floors as well as ceilings. So the railroad barons were already in trouble by the late 1880s, despite the millions of dollars in subsidies. The "protection" became a stranglehold, and by the late 1950s, the passenger-carrying railroads were in trouble. By the early 1970s, they were bankrupt. (Long-haul freight railroads are still able to compete.) The government now owns and mismanages many of them (Amtrak, Conrail).

The incomes of the members of the industries and professions that are now directly financed and/or directly policed by the government necessarily fall. Envy is loose in the land. The popular press and television reporters have accomplished their goal. The public will not permit "profiteering." The politicians will not permit it. Prices, wages, and fees are controlled, and work loads increase. Regulatory agencies each claim a piece of the action, and the multiplication of paperwork is endless. The formerly independent producers, who answered directly to the formerly independent consumers, now answer to a multitude of bureaucrats and enraged customers who detect the collapse of productivity on the part of the now-controlled suppliers. Most suppliers lose, most consumers lose, and a real crisis is produced.

Conclusion: Avoid the Bait, Rely on Principle

The answer, philosophically, is to avoid sniffing at the bait. This must be done on principle. It would help if businessmen understood the chain of events which follows from the acceptance of a government subsidy. Yet even if this chain of events is not understood, men should still be able to recognize a violation of basic moral principle when they see it. They should understand that the coercive power of the state should not be used to benefit one group at the expense of another. Such power is inevitably misused, if not immediately, then ten years or fifty years down the road. The precedent is evil; the results following it will also be evil.

The problem, as indicated by Hayek's statement which introduced this paper, is that businessmen like the seeming safety of a government-restricted market, at least in the early stages, when they are given some power to set standards and direct production. Businessmen can make very good bureaucrats, too. The market is relentless. It forces men to meet the demands of a fickle public. Businessmen think they can find an escape in some sort of government business partnership. That is the grand illusion.

Those who are offered the subsidy must say no very early. There are strings attached to government money or power, and they become chains if the subsidies are allowed to continue. It is easier to say no before the addiction process begins, before costs rise to meet income levels. The longer a violation of principle continues, the more difficult the "withdrawal" process becomes

1. Hayek published this in Individualism and Economic Order (University of Chicago Press, [1948] 1963), pp. 107-08. This is taken from Hayek's address to the Mont Pelerin Society in 1947.

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